Alternative business loans can hurt contractors

Merchant cash advance loans for businesses are the equivalent of payday loans for consumers.

The entrepreneur has to find less expensive and more patient sources of capital to continue to grow and sustain their businesses.

As the supply of these loans drops, the rise in business owners defaulting will increase until there is no longer a market for these loans.

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During the economic crisis of 2008, the credit market to businesses dried up. However, alternative financing for businesses came to the rescue. Merchant cash advance loans, and invoice financing stepped in to fill the void left by the banks. These loans are a great first step solution for companies; but they are just that, a first step solution. The loans or “advances,” as they are known in the industry, are there to solve short-term cash issues for small businesses.

However, if a business does not have a plan to move past this type of funding, they are probably going to fail.

Merchant cash advance loans for businesses are the equivalent of payday loans for consumers. Merchant cash advance loans are there when you need them and can cost around 30% in interest by the time the loans are repaid. Just like payday loans, they solve a short-term need for borrowers in a cash crunch; however, for many of these borrowers the cure is worse than the disease.

Accounts receivable and purchase order loans are a great way to expedite cash flow because these loans allow business owners to borrow against invoices. Many business owners that perform government and commercial contracts must often wait 30, 60, and sometimes up to 90 days to be paid. In order for these entrepreneurs to stay in business or allow them to take on more business, accounts receivable and purchase order loans are a viable solution.

The rates on this type of financing on average are 2% of the value of the invoice. Two percent may sound like a good number; however, when it is 2% of every invoice and a typical contractor submits several invoices every month, the total interest payments for the year is astronomical. Therefore, accounts receivable and purchase order financing is a great first solution but the entrepreneur has to find less expensive and more patient sources of capital to continue to grow and sustain their businesses.

Unfortunately, lower cost and more patient capital can only be obtained through two sources: Small Business Administration secured loans or private capital. Most small business owners do not know where to look or how to access private capital and SBA loans are some of the most challenging loans to qualify for, with a large percentage of the business owners that apply being turned away.

Merchant cash advance and accounts receivable loans are very profitable for lenders, especially now with the securitization of these loans. As profit margins increase for some lenders, it will put pressure on other lenders to put more money on the street and at that point we are in the boom portion of this vicious cycle. I think it would be very naïve not to consider that lenders becoming more interested in quantity instead of quality, just like what happened in the subprime mortgage industry. The small business community will soon become saturated with these loans because they are easily accessible albeit outrageously expensive. As a result, these businesses will have some short-term cash flow pressures resolved, but ultimately become crippled by these types of loans.

Borrowers that become dependent on these types of loans but fail to produce significant growth in profits will, unfortunately, fail and more significantly, default. This painfully reminds me of the refinance and cash-out boom on residential real estate. Borrowers could borrow more than they could afford and supplement their payments with the cash out, and then refinance again when the money ran out. That only worked as long as real estate prices continued to climb and lenders continued to lend, but nobody linked the two. Real estate values only went up based on the lenders’ willingness to keep lending and, without the lending, the values dropped, thus causing the Great Recession.

Here is our current situation: Small businesses create demand for these loans, and as long as the entrepreneurs can get these loans, they are going to repay these loans. However, once the defaults begin, there will be a reduced supply of capital from investors for these loans and, as a result, fewer contractors will have access to these loans thus causing more defaults. As the supply of these loans drops, the rise in business owners defaulting will increase until there is no longer a market for these loans and every business owner dependent on these loans eventually defaults.

Small businesses are the engine of growth for jobs in the U.S. and with the bubble in alternative financing to businesses starting to form, the bust is not far away. President Obama and Congress need to put a comprehensive bill in place to help get patient, less-expensive capital in to the hands of entrepreneurs. If the government fails to act, the bust will destroy businesses and ultimately destroy jobs and communities. Moreover, at the time of this writing, I cannot imagine what type of bailout from the government or the Federal Reserve could stabilize a collapse of lending of this magnitude if the government does not step in now.

The new SEC rule allowing businesses to publicly solicit capital is a good first step but it needs to be coupled with a tax incentive to attract investors. In addition, Congress should consider less stringent credit requirements for SBA secured loans. Many entrepreneurs suffered losses and setbacks during the Great Recession and, in return, some of them were late on payments causing their credit scores to drop. Washington provided massive bailouts to big companies and the banks, and Washington even went the extra mile with homeowners and the unemployed. Washington did not, however, bailout small businesses, so I believe at the minimum that Washington should consider reducing the FICO score requirements for entrepreneurs seeking SBA loans, as long as the business is able to meet all of the other SBA lending requirements.

Washington must do something to assist small businesses to access less expensive, more patient forms of capital and stave off this new wave of predatory lending that our entrepreneurs cannot afford to live without.

Troy Holland is CEO of HIC Financial Group, Baltimore, Maryland. He can be reached at 410/412-3322 Ext. 301, or at 443/341-4308

Discuss this Article 3

The appearance of such financial options as unsecured personal loans for bad credit and merchant cash advance loans for businesses is without any doubt a great helping hand for consumers and businesses as well, but without any doubt its better to find more affordable and cheaper options when in strong need of money.

I think lumping all merchant cash advances in as "predatory loans" is not quite accurate. There are some cash advance companies who certainly could be classified as such, but there are also many that do not fit into that description.

There is also a reason the cost of money is higher on these types of loans, and the biggest factor is that these are not collateralized, which of course constitutes a big risk factor for the company facilitating the advance. In the case of a default the lending company generally has no basis to collect what is owed to them. This built in mechanic of the merchant cash advance would make it a terrible idea for an advance company to overcharge the merchant, since they do not want to set up an advance that they cannot collect the full amount back on.

Any contractor taking this type of advance should also go into it knowing that the burden of responsibility ultimately lies in you, the recipient. There are avenues to take multiple advances at once, but once someone goes down that route it can become difficult for them to not rely on this type of funding. However, if the merchant receiving the advance uses it for it's implied purpose-- as a "bridge" type of loan to help get them from point A to point B-- and then continues business as normal afterwards then there is no threat of them becoming reliant on this type of funding. As such, contractors (or any merchants) looking to take this type of advance should not wave it off entirely, but should rather go into it with an educated concept of how it works so they know exactly what they are getting into, and to avoid the pitfalls that some companies end up taking that lead to them becoming "hooked" on this type of funding.

I agree that the CEO's of these companies may not be predatory, however, the ISO and the sales reps are pushing these loans hard. In addition, these lenders are putting ALL ASSET LIENS on these borrowers. In the contractor space if a contractor goes the route of "cash advance" all of the contractors assets are pledged including all current and future receivables. I'm not blaming the lender, I agree with Holland, Washington better do something because when the only loans available to contractors without assets cost 30% and more in interest, we have a problem.